WHY do we use the "lag method" to deduct California Franchise Taxes?

I once got a call (on behalf of another CPA) asking WHY an accrual-basis taxpayer's deduction for California Franchise Taxes ("CFT") must be taken on the "lag method."

In short, the "lag method" involves taking a deduction for the CFT in the year following that in which the taxable income arose from which it was determined (e.g., CFT computed at $100x earned in 20x1, times 8.84% is $8.84x and is deductible in 20x2 for federal income tax purposes).  While this rule has applied for many years, the reason for it doesn't seem to be widely known.

In a nutshell, the CFT deduction is subject to the “lag method” for federal tax purposes due to Internal Revenue Code section 461(d).  But wait, you say...section 461(d) doesn't say anything about CFT!  All it says is the following:

461(d) Limitation on acceleration of accrual of taxes.

      (1) General rule. - In the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent that the time for accruing taxes is earlier than it would be but for any action of any taxing jurisdiction taken after December 31, 1960, then, under regulations prescribed by the Secretary, such taxes shall be treated as accruing at the time they would have accrued but for such action by such taxing jurisdiction.

      (2) Limitation. - Under regulations prescribed by the Secretary, paragraph (1) shall be inapplicable to any item of tax to the extent that its application would (but for this paragraph) prevent all persons (including successors in interest) from ever taking such item into account.

So what does the above text have to do with delaying the deduction for CFT?  Well, it goes back to the general rules for timing (section 461) as well as a bit of history.

At the risk of boring some readers, a bit of background is warranted here.  Any accrual-basis taxpayer wishing to take an expenditure into account (whether deducting or capitalizing it) must first meet the all events test.  Moreover, such item cannot be taken into account until there is economic performance.

Section 461(h)(4) provides that "the all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy." In other words, the liability in question (e.g., for the tax owed to California) must (1) be unconditionally due to the person to whom it's owed, and (2) must be able to be reasonably determined as of the day it's to be taken into account (i.e., generally the last day of the tax year).

Section 461(h)(2) and Treas. Reg. section 1.461-4 provide the rules for determining when economic performance occurs.  In the case of taxes, economic performance occurs when those taxes are paid, in keeping with Treas. Reg. section 1.461-4(g)(6).

Based on the section 461 rules above, why wouldn't the CFT be properly accrued as of the last day of the year?  After all, at year-end isn't (1) the tax reasonably ascertainable, (2) the amount unconditionally due, and (3) assuming estimates were paid throughout the year economic performance was met (or the taxpayer had adopted the recurring item exception of section 461(h)(3) and Treas. Reg. section 1.461-5)?

The answer, is currently yes, but used to be no. And that's where the history comes in.  

You see, in the early 1970s, California modified its franchise tax regime which imposed a tax on most corporations doing business in the state.  Before this change, a corporation's franchise tax would be measured on the corporation's current-year income, but would apply to the exercise of its corporate franchise (i.e., the right to do business in California) starting with the first day of the corporation's following year.  As a result:

• All events test met (unconditionally due):   No, because the tax was not owed until the company started exercising its corporate franchise on the first day of the next year.
• All events test met (reasonably ascertainable):   Yes, since taxable income and the tax rate were "knowable" at year-end.
• Economic performance met:  Presumably Yes, as noted above.

In doing so, California took action (after 12/31/1960) that effectively accelerated the accrual date of the CFT.  This invoked section 461(d)(1), thereby negating that acceleration for federal income tax purposes.

So there you have it.


Final notes:  

• Too often, taxpayers (and their tax professionals) don't fully understand the rules for claiming deductions in the correct year.  That means write-offs are sometimes being taken too early and sometimes too late.
• The CFT tax deduction is just one example of how the "income tax accounting" rules can be surprisingly complicated and counterintuitive.
• I spent considerable time in KMPG's Washington National Tax practice and have personally seen how timing issues can have a multi-million dollar tax impact on someone's tax bill.  Moreover, timing issues exist in virtually every industry and area of tax, so knowing the rules and how to apply them will (literally) affect most individuals and businesses.  Let me know how I can help you (or your advisor) navigate this often-misunderstood area and avoid costly mistakes!

For more discussion of this rule, the following are enlightening.

• Rev. Rul.  2003-90 (http://www.irs.gov/pub/irs-drop/rr-03-90.pdf)
• Wells Fargo & Co. v. U.S., No. 09-CV-2764 (D. Minn. 8/10/12) (http://www.gpo.gov/fdsys/pkg/USCOURTS-mnd-0_09-cv-02764/pdf/USCOURTS-mnd-0_09-cv-02764-5.pdf)

State Research Tax Credits - You May Be Entitled To More Than You Thought

Despite the sad fact that the federal research credit under section 41 has expired for amounts paid or incurred after December 31, 2009 (and which will hopefully be extended again), certain states still provide credits for qualified expenditures. However, many states impose additional requirements on the computation of the state credits (e.g., activities having been conducted in the state, computations of base amounts, etc.) that are easily overlooked, but can have substantial impact. Accordingly, it makes sense to revisit how these state rules might affect your clients.

Note: At the time of this writing more than half of the states provide some sort of tax credit for expenses paid or incurred with respect to a taxpayer’s qualified research activities. Since a review of each state’s provisions is beyond the scope of this article, we’ll focus on some of the more interesting California provisions under Cal. Revenue & Taxation Code section 23609. In addition, the federal and California research credit provisions also provide benefits for amounts paid for “basic research,” but those are also outside the scope of this article.

Background

The federal research credit was originally enacted in 1981 and was intended in large part to spur domestic innovation. It took the form of a nonrefundable credit against income tax available to taxpayers for certain qualified expenditures that exceeded a defined “base amount.” Even though it expired as of the end of 2009, many commentators believe that it will return (although possibly with additional changes), as it has many times before.

In computing the credit for both federal and California purposes, it is important to remember that there are various methods to consider, depending on whether the company had sufficient activity in the 1984 – 1988 time period, whether the taxpayer wants to elect an alternative computation method, whether the taxpayer is a member of a group of businesses that must aggregate their activities, and so on. However, for the sake of this discussion, the standard method of computing the credit is as follows (for both federal and California) for businesses that are not “start-ups.”

• Take the total of the taxpayer’s qualified research expenditures for tax years beginning after December 31, 1983, and before January 1, 1989.
• Divide that total by total gross receipts for those same years.
• The resulting percentage is the “fixed base percentage,” which, per section 41(c)(3)(C), cannot be greater than 16%.
• Take the average gross receipts for the 4 years preceding the current year and multiply that amount by the fixed base percentage. The result is the “tentative base amount.”
• Compare the tentative base amount against the current year qualified expenditures.
• If the current year qualified expenditures are less than the tentative base amount, no research credit is available.
• If the current year qualified expenditures are greater than the tentative base amount, then the “increment” is the lesser of (1) the difference between the total current year qualified expenditures and the tentative base amount, or (2) one-half of the current year qualified expenditures.
• The credit is then determined by multiplying the credit rate (20% for federal, 15% for California) by the above increment.
• Finally, the taxpayer needs to decide if they prefer to follow section 280C(c) and reduce their otherwise deductible/capitalizable research expenditures or instead elect a reduced credit that reflects an impact similar to that of section 280C(c).

Note: In this context, a start-up company is one that had both qualified research expenses and gross receipts either (1) for the first time in a taxable year beginning after December 31, 1983; or (2) for fewer than three taxable years beginning after December 31, 1983, and before January 1, 1989.

California R&TC section 23609

The California research credit (effective as of 1987), while based on the federal credit, does contain some notable differences. In the right circumstances, those differences sometimes provide substantial (and unexpected) benefits to those who read the California rules carefully.

The first key difference in the California rules restricts the credit by the location of the qualifying activity. Specifically, Cal. Revenue & Taxation Code (“R&TC”) section 23609(c)(2) provides that qualified research includes only research conducted in California. While this makes sense in that California doesn’t want to provide incentives outside of the state, it places the responsibility on the taxpayer to not only ensure its in-house expenses (e.g., wages, supplies) are for California activities, but contract research expenses are as well. This means that the taxpayer would have to be able to establish that its subcontractors performed their work in California as well to qualify those expenses for the California research credit.

The second key difference is one with which many California practitioners seem unfamiliar. In fact, I have encountered at least two relatively recent cases in which this difference in California law has provided the taxpayers with additional California research credits in excess of six figures that they otherwise might have missed! That provision is the one under R&TC section 23609(h)(3) which reads as follows:

“Section 41(c)(6) of the Internal Revenue Code, relating to gross receipts, is modified to take into account only those gross receipts from the sale of property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business that is delivered or shipped to a purchaser within this state, regardless of f.o.b. point or any other condition of the sale.”

In addition, California Publication 1082 (“Research & Development Credit: Frequently Asked Questions”), section 8 provides the following (in relevant part):

“Excluded receipts are items such as California “throwback” sales for apportionment purposes, as well as, receipts from services, rents, operating leases and interest. In addition, royalties and license payments are generally excluded from the definition of gross receipts for research credit purposes…This California definition of gross receipts applies to both the average annual gross receipts for the prior four years and the base years (1984-1988).”

Note: While the Publication does not have the weight of statutory authority, it is seemingly consistent with the statutory language noted above, and does represent the Franchise Tax Board’s official stance, so ignore it at your peril.

As innocuous as this second item may appear, it represents a fundamental conceptual difference in the computation of the California credit. In short, it redefines “gross receipts” for California purposes as basically only including inventory sales to California purchasers. So what does this really mean? It means that not only should practitioners expect the fixed base percentage to usually differ between federal and California, it also means that average gross receipts for the preceding 4 years will usually differ as well. Moreover, this can (in the right circumstances) provide a large (often beneficial) difference to the taxpayer.

For the sake of illustration, please consider the following simple example:

Abbreviations

• QREs = Qualified research expenditures
• GR = Gross receipts

Assumptions

• Taxpayer develops new/improved products for sale to customers
• All qualified activities are conducted in California
• Current tax year is 2009

What this example demonstrates is the fact that a taxpayer blindly using the federal rules in this case would have erroneously forgone $840,000 of California research credits to which it was entitled. Fortunately, the taxpayer in this case should be able to file an amended return and claim those credits, but having to go through that process isn’t the ideal way to claim that benefit.

Conclusion

In discussions with other practitioners, relatively few seem to be well-versed in the intricacies of the California research credit. Fortunately however, it’s not that complicated to take the time to read carefully through what amounts to the roughly two and a half pages of Cal. R&TC 23609.

Similarly, for those with clients conducting qualified research in other states, there could be some hidden gems there as well.